4-15-1 CHAPTER 3 The Financial Environment: Markets, Institutions, and Investment Banking ❂...

4-15-1

CHAPTER 3CHAPTER 3The Financial The Financial

Environment: Markets, Environment: Markets, Institutions, and Institutions, and Investment BankingInvestment Banking

❂ Financial marketsFinancial markets❂ Financial institutionsFinancial institutions❂ Stock Market EfficiencyStock Market Efficiency

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The Financial MarketThe Financial Market

A market is a venue where goods and A market is a venue where goods and services are exchanged.services are exchanged.

A financial market is a place where A financial market is a place where individuals and organizations wanting to individuals and organizations wanting to borrow funds are brought together with borrow funds are brought together with those having a surplus of funds.those having a surplus of funds.

In a well-functioning economy, capital flows In a well-functioning economy, capital flows efficiently from those who supply capital to efficiently from those who supply capital to those who demand it.those who demand it.

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The Financial The Financial MarketsMarkets

Suppliers of capital – individuals and Suppliers of capital – individuals and institutions with institutions with ““excess fundsexcess funds””. . These groups are saving money and These groups are saving money and looking for a rate of return on their looking for a rate of return on their investment.investment.

Demanders or users of capital – Demanders or users of capital – individuals and institutions who need individuals and institutions who need to raise funds to finance their to raise funds to finance their investment opportunities. These groups investment opportunities. These groups are willing to pay a rate of return on are willing to pay a rate of return on the capital they borrow.the capital they borrow.

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Flow of FundsFlow of Funds

Three financial phasesThree financial phases

Young adults borrowYoung adults borrow

Older working adults saveOlder working adults save

Retired adults use savingsRetired adults use savings

Funds transferred from savers to Funds transferred from savers to borrowersborrowers

Direct transferDirect transfer

Investment banking houseInvestment banking house

Financial intermediaryFinancial intermediary

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The Capital Formation The Capital Formation ProcessProcess

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Market EfficiencyMarket Efficiency

Economic Efficiency Economic Efficiency - Funds are allocated - Funds are allocated to their optimal use at the lowest coststo their optimal use at the lowest costs

Informational Efficiency Informational Efficiency - Investment - Investment prices are adjusted quickly to reflect prices are adjusted quickly to reflect current informationcurrent information

Weak-form - all information contained in past Weak-form - all information contained in past price movements is reflected in current market price movements is reflected in current market pricesprices

Semistrong-form - current prices reflect all Semistrong-form - current prices reflect all publicly available informationpublicly available information

Strong-form current prices reflect all Strong-form current prices reflect all pertinent information, both public and privatepertinent information, both public and private

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Types of financial Types of financial marketsmarkets

Money versus capital marketsMoney versus capital markets

Debt versus equity marketsDebt versus equity markets

Primary versus secondary marketsPrimary versus secondary markets

Derivatives marketsDerivatives markets

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General Stock Market General Stock Market ActivitiesActivities

The secondary market - trading in the The secondary market - trading in the outstanding, previously issued shares of outstanding, previously issued shares of established, publicly owned companiesestablished, publicly owned companies

The primary market - additional shares The primary market - additional shares sold by established, publicly owned sold by established, publicly owned companiescompanies

IPO market - new public offerings by IPO market - new public offerings by privately held firmsprivately held firms

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Stock MarketsStock Markets

Physical stock exchangesPhysical stock exchanges NYSE, AMEX, and regional exchangesNYSE, AMEX, and regional exchanges

Exchange membersExchange membersFloor brokersFloor brokers

SpecialistsSpecialists

To have a stock listedTo have a stock listedApply to the exchangeApply to the exchange

Pay a relatively small feePay a relatively small fee

Meet the exchange’s minimum requirementsMeet the exchange’s minimum requirements

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Stock Market Listing Stock Market Listing RequirementsRequirements

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Stock MarketsStock Markets

Over-the-Counter Markets and the NasdaqOver-the-Counter Markets and the Nasdaq

Network of brokers and dealersNetwork of brokers and dealers

Auction marketAuction market

Organized Investment NetworkOrganized Investment Network

Electronic Communications NetworksElectronic Communications Networks

NasdaqNasdaq

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Regulation of Regulation of Securities MarketsSecurities Markets

Securities and Exchange Commission Securities and Exchange Commission (SEC)(SEC)Jurisdiction over most interstate Jurisdiction over most interstate offerings of new securities to the offerings of new securities to the general publicgeneral public

Regulation of national securities Regulation of national securities exchangesexchanges

Power to prohibit manipulation of Power to prohibit manipulation of securities’ pricessecurities’ prices

Control over stock trades by corporate Control over stock trades by corporate insidersinsiders

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The Investment Banking The Investment Banking ProcessProcess

Investment BankerInvestment Banker

Helps corporations design securities Helps corporations design securities attractive to investorsattractive to investors

Buys these securities from the Buys these securities from the corporationcorporation

Resells the securities to investorsResells the securities to investors

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Raising Capital: Stage I DecisionsRaising Capital: Stage I Decisions

1.1. Dollars to be raised Dollars to be raised

2.2. Type of securities usedType of securities used

3.3. Competitive bid versus negotiated Competitive bid versus negotiated dealdeal

4.4. Selection of an investment bankerSelection of an investment banker

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Raising Capital: Stage II DecisionsRaising Capital: Stage II Decisions1.1. Reevaluating the initial decisionsReevaluating the initial decisions

2.2. Best efforts or underwritten issuesBest efforts or underwritten issues Underwritten Arrangement - investment bank Underwritten Arrangement - investment bank

guarantees the sale by purchasing the guarantees the sale by purchasing the securities from the issuersecurities from the issuer

Best Effort Arrangement - investment bank Best Effort Arrangement - investment bank gives no guarantee that the securities will gives no guarantee that the securities will be soldbe sold

3.3. Issuance (flotation) CostsIssuance (flotation) Costs

4.4. Setting the offering priceSetting the offering price

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Selling ProceduresSelling ProceduresUnderwriting SyndicateUnderwriting Syndicate: A syndicate of : A syndicate of investment firms formed to spread the risk investment firms formed to spread the risk associated with the purchase and distribution associated with the purchase and distribution of a new issuance of securitiesof a new issuance of securities

Lead or Managing UnderwriterLead or Managing Underwriter: The member of : The member of an underwriting syndicate who actually an underwriting syndicate who actually manages the distribution and sale of a new manages the distribution and sale of a new security offeringsecurity offering

Selling GroupSelling Group: A network of brokerage firms : A network of brokerage firms formed for the purpose of distributing a new formed for the purpose of distributing a new issuance of securitiesissuance of securities

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Shelf RegistrationsShelf Registrations

Securities registered with the SEC Securities registered with the SEC for sale at a later datefor sale at a later date

Held “on the shelf” until the saleHeld “on the shelf” until the sale

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Maintenance of the Secondary Maintenance of the Secondary MarketMarketWhen a company is going public for When a company is going public for the first time, the investment banker the first time, the investment banker is obligated to maintain a market for is obligated to maintain a market for the shares after the issue has been the shares after the issue has been completed.completed.

The lead underwriter agrees to “make The lead underwriter agrees to “make a market” in the stock and keep it a market” in the stock and keep it reasonably liquid.reasonably liquid.

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Types of Financial Types of Financial IntermediariesIntermediaries

Commercial banksCommercial banks

Credit unions Credit unions

Savings and loan associationsSavings and loan associations

Mutual fundsMutual funds

Whole life insurance companiesWhole life insurance companies

Pension fundsPension funds

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The Role of Financial The Role of Financial IntermediariesIntermediaries

Facilitate the transfer of funds from those Facilitate the transfer of funds from those who have funds (savers) to those who need who have funds (savers) to those who need funds (borrowers) funds (borrowers)

Manufacturing a variety of financial Manufacturing a variety of financial products that take the form of either loans products that take the form of either loans or savings instrumentsor savings instruments

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Benefits of Financial Benefits of Financial IntermediariesIntermediaries

Reduced costsReduced costs

Risk/diversificationRisk/diversification

Funds divisibility/poolingFunds divisibility/pooling

Financial flexibilityFinancial flexibility

Related servicesRelated services

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International Financial International Financial MarketsMarkets

U.S. stock markets represent less than U.S. stock markets represent less than 50% of the total value worldwide50% of the total value worldwide

U.S. markets still dominate the stock U.S. markets still dominate the stock markets in other countriesmarkets in other countries

U.S. investors can participate in U.S. investors can participate in international markets by using American international markets by using American Depository Receipts - mutual funds that Depository Receipts - mutual funds that hold stocks or foreign securities hold stocks or foreign securities certificates issued in dollar certificates issued in dollar denominationsdenominations

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Financial Organizations Financial Organizations in Other Parts of the in Other Parts of the

WorldWorldU.S. financial institutions are more U.S. financial institutions are more heavily regulated heavily regulated

U.S. financial institutions face greater U.S. financial institutions face greater limitations on branching, services and limitations on branching, services and relationships with non-financial businessesrelationships with non-financial businesses

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CHAPTER 5CHAPTER 5The Cost of Money The Cost of Money (Interest Rates)(Interest Rates)

Cost of Money and factors that effect Cost of Money and factors that effect cost of moneycost of money

How are interest rates determinedHow are interest rates determined

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Realized Returns Realized Returns (Yields)(Yields)

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Factors that Affect Factors that Affect

the Cost of Moneythe Cost of Money Production opportunitiesProduction opportunities

Time preferences for consumptionTime preferences for consumption

RiskRisk

InflationInflation

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The Cost of The Cost of MoneyMoney

What do we call the price, or What do we call the price, or cost, of debt capital?cost, of debt capital?The Interest RateThe Interest Rate

What do we call the price, or What do we call the price, or cost, of equity capital?cost, of equity capital?Return on Equity = Dividends + Return on Equity = Dividends + Capital GainsCapital Gains

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Interest Rate LevelsInterest Rate Levels

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Determinants of Market Interest Determinants of Market Interest RatesRates

r = Quoted or nominal rate rRF = The quoted risk-free rateRP = Risk premium RP = DRP + LP + MRPDRP = Default risk premium LP = Liquidity premiumMRP = Maturity risk premium2929

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““Real” versus “Nominal” Real” versus “Nominal” RatesRates

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r = represents any nominal rate

r* = represents the “real” risk-free rate of interest. Like a T-bill rate, if there was no inflation. Typically ranges from 2% to 4% per year.

rRF = represents the rate of interest on Treasury securities.

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IP = Inflation premiumDRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium

Premiums Added to r* for Different Types Premiums Added to r* for Different Types of Debtof Debt

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IP MRP DRP LP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

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The Term Structure of The Term Structure of Interest RatesInterest Rates

Term structure: the relationship between Term structure: the relationship between interest rates (or yields) and maturitiesinterest rates (or yields) and maturities

A graph of the term structure is called the A graph of the term structure is called the yield curve.yield curve.

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U.S. Treasury Bond Interest Rates U.S. Treasury Bond Interest Rates on Different Dates (Yield Curves)on Different Dates (Yield Curves)

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Three Explanations for Three Explanations for the the

Shape of the Yield Shape of the Yield CurveCurve

Liquidity Preference TheoryLiquidity Preference Theory

Expectations TheoryExpectations Theory

Market Segmentation TheoryMarket Segmentation Theory

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Liquidity Preference Liquidity Preference TheoryTheory

Lenders prefer S-T securities Lenders prefer S-T securities because they are less subject to because they are less subject to interest rate risk and are thus interest rate risk and are thus more easily bought or sold in the more easily bought or sold in the market.market.

Thus, S-T rates should be low, and Thus, S-T rates should be low, and the yield curve should be slope the yield curve should be slope upward.upward.

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Shape of curve depends on Shape of curve depends on investors’ expectations about investors’ expectations about future inflation rates.future inflation rates.

If inflation is expected to If inflation is expected to increase, S-T rates will be low, increase, S-T rates will be low, L-T rates high, and vice versa. L-T rates high, and vice versa. Thus, the yield curve can slope Thus, the yield curve can slope up OR down.up OR down.

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• Step 1: Step 1: – Find the average expected inflation rate Find the average expected inflation rate

over years 1 to N:over years 1 to N:

Calculating Interest Calculating Interest Rates Rates


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• Inflation for Year 1 is 5%.Inflation for Year 1 is 5%.

• Inflation for Year 2 is 6%.Inflation for Year 2 is 6%.

• Inflation for Year 3 and beyond is 8%.Inflation for Year 3 and beyond is 8%.– r* = 3%r* = 3%

– MRPMRPtt = 0.1% (t-1) = 0.1% (t-1)

IP1 = 5%/ 1.0 = 5.00%IP10 = [ 5 + 6 + 8(8)] / 10 = 7.5%IP20 = [ 5 + 6 + 8(18)] / 20 = 7.75%

Must earn these IPs to break even vs. inflation;these IPs would permit you to earn r* (before taxes).

Example:Example:

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MRP1 = 0.1% x 0 = 0.0%

MRP10= 0.1% x 9 = 0.9%

MRP20= 0.1% x 19 = 1.9%


Expectations Theory:Expectations Theory:• Step 2: Find MRP based on this equation: Step 2: Find MRP based on this equation:

MRPMRPtt = 0.1% (t - 1) = 0.1% (t - 1)

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• Step 3: Add the IPs and MRPs to r*:Step 3: Add the IPs and MRPs to r*:rrRFtRFt = r* + IP = r* + IPtt + MRP + MRPtt

Assume r* = 3%.Assume r* = 3%.

1-Yr:rRF1 = 3% + 5.0% + 0.0%= 8.0%10-Yr: rRF10 = 3% + 7.5% + 0.9%= 11.4%20-Yr: rRF20 = 3% + 7.75%+ 1.9%= 12.7%


Expectations Theory:Expectations Theory:

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Market Segmentation Market Segmentation TheoryTheory

• Borrowers and lenders have preferred Borrowers and lenders have preferred maturitiesmaturities

• Slope of yield curve depends on supply and Slope of yield curve depends on supply and demand for funds in both the L-T and S-T demand for funds in both the L-T and S-T markets (curve could be flat, upward, or markets (curve could be flat, upward, or downward sloping)downward sloping)

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Other Factors That Other Factors That Influence Interest Rate Influence Interest Rate

LevelsLevels• Federal Reserve PolicyFederal Reserve Policy

• Federal deficitsFederal deficits

• International Business (Foreign Trade International Business (Foreign Trade Balance)Balance)

• Business ActivityBusiness Activity

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Interest Rate Levels Interest Rate Levels and Stock Pricesand Stock Prices

• The higher the rate of interest, the lower The higher the rate of interest, the lower a firm’s profitsa firm’s profits

• Interest rates affect the level of economic Interest rates affect the level of economic activity, and economic activity affects activity, and economic activity affects corporate profitscorporate profits

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The Cost of Money as a The Cost of Money as a Determinant of ValueDeterminant of Value

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